Friday, October 24, 2014

Don't Fight The Fed?

Things were looking grim last week, especially on Wednesday, when the Dow Jones Industrial Average was at one point down by 460.

The CBOE VIX indicator soared to the mid-20s for the first time in two years. Fear was palpable as investors had a classic panic attack.

But then, like the cavalry in those classic John Ford westerns, the Federal Reserve rode to the rescue.

James Bullard, president of the Federal Reserve Bank of St. Louis, said inflation far below its 2% target could lead the Fed to “go on pause on the taper … and wait until we see how the data shakes out into December.” The Fed is on track to finish “tapering” its extraordinary bond buying, or quantitative easing (QE3), at next week’s meeting.

But, he added: “If the market is right and it’s portending something more serious for the U.S. economy, then the committee would have an option of ramping up QE [in December].”

Boston Fed President Eric Rosengren later said QE3 should end next week, but he could “easily imagine” not raising rates until 2016.Translation: We’ve got your back. Don’t fight the Fed.

Investors got the message. The S&P 500 Index advanced for three straight days and the VIX fell under 20 again.

Bullard was only the latest Fed official whose words or actions “just happened” to boost the stock market when it was down.

“They are definitely in the market-manipulation business, and nothing has changed,” said James Bianco, president of Bianco Research LLC in Chicago and a longtime student, and critic, of the Fed.

Called the “Greenspan/Bernanke put,” the Fed’s willingness to jump in when stocks fall dates back a quarter-century.

“The put option is back. If the market sells off enough, they will give us QE4,” Bianco told me.

Conspiracy theorists have pinned it on a government “Plunge Protection Team” that wants to keep stocks from crashing at all costs.

Aug. 31, 2012: In his annual speech in Jackson Hole, Wyo., Fed Chairman Ben S. Bernanke all but announced the third round of QE, extraordinary bond buying of $85 billion a month. The S&P 500, which had languished after a nearly 10% decline, rallied from 1,399 points and hasn’t corrected substantially until now.

Sept. 22, 2011: Following a 19.4% stock sell-off amid a debt crisis in Europe and the U.S., the Fed launched Operation Twist, in which it sold short-term and bought long-term securities to push down long rates. After first slipping, the S&P 500 resumed a multiyear take-off that, with a little help from the Fed, ultimately drove it 80% higher.

Aug. 27, 2010: In another famous Jackson Hole speech, Bernanke vowed the Fed would “do all that it can” and would “provide additional monetary accommodation through unconventional measures if … necessary.” After a 16% correction in the S&P 500, the Fed’s purchase of $600 billion in securities through QE2 would help push stocks 22.8% higher, according to Bianco Research.

Nov. 25, 2008: In the heat of the financial crisis, Bernanke announced the Fed’s first bond-buying program in which it wound up purchasing $1.7 trillion worth of securities. QE helped launch the new bull market and drove the S&P 500 up 50%.

“Three times they put down markers they were going to end QE,” Bianco said. “In all three cases — 20%, 17%, 10% down in the stock market — they reversed.”

As this terrific chart shows, Bianco Research estimates that during all the QEs, stocks rose by 147.5%. Subtracting periods of QE, they lost 27.5%.

Back in the fall of 1998, Alan Greenspan cut rates three times during the Asian/Russian financial crisis and after the bailout of Long-Term Capital Management. That set the stage for the 1990s bull market’s final blow-out phase.

And after the 1987 stock market crash, when the Dow fell 22.6% in a single day, Greenspan’s Fed bought $17 billion worth of bonds (a lot in those days) and declared the central bank ready “to serve as a source of liquidity to support the economic and financial system.” The panic eased and the bull continued for years.

As in 1987, the specter of 1929 still haunts the Fed. “They are afraid of the market going down and they will be blamed,” explained Bianco. If that means “guiding” the stock market, so be it.

Don’t get me wrong: This bull market reflects a genuine, albeit below-normal, recovery, and the U.S. is much stronger than the rest of the world. The Fed helped by giving the economy time and breathing room.

But the emergency is over and once accumulated, power is not easily shed. If this pattern continues, the U.S. economy and markets will never stand on their own feet again.

This may be the ultimate test for Janet Yellen and could determine whether she’s remembered as a great Fed chair or just another caretaker of a dead-end course if there ever was one.

"Twenty years ago, I'm fairly sure people said 'don't fight the Bank of Japan.' Two months ago, you could have said 'don't fight the European Central Bank,'" Gayed states. "Now, with the Federal Reserve ending quantitative easing as worldwide economic data falters, it appears the time to 'fight the Fed' has come."

Conventional wisdom holds that stock markets collapsed because the Ebola virus scare and stagnant growth in Europe. But this, he says, is not a typical correction."Something fundamental has changed in the market's perception," he says, stressing the stocks have fallen and inflation expectations have collapsed even in the face of trillions of dollars of central bank stimulus. "So, what happens if my belief is right that the last great bubble is bursting? It likely means a significant reset could soon occur unless reflation hope kicks in with gusto. Hard to imagine."

Economic growth and a bull market coincide with rising inflation expectations. Yet central banks have been unable to prevent disinflation."Fight the Fed? You sure they are going to get that inflation target when the market itself is screaming they won't, at the same time quantitative easing is ending?"

The Treasury Inflation Protected Securities (TIPS) market does indeed suggest that disinflation, which can smother economic growth, may be looming, Reuters reports. Investors have been unloading TIPS, which provide protection against inflation, in recent months, due slowing global economic growth, most notably in Europe, as well as falling oil prices and a strong dollar.

"The CPI definitely set the tone. The stronger dollar and weaker energy prices are definitely having a major impact," Martin Hegarty, co-head of inflation-linked bonds at BlackRock, tells Reuters.

Although the world economy is currently slowing, John Williams, president of the San Francisco Fed, tells Reuters he expects the Fed to raise interest rates in mid-2015. However, it might delay a rate hike if inflation is significantly below its 2 percent target and wages remain stagnant.

"If we don't see any improvement in wages," he explains, "that would be a sign that we still have a lot of slack in the economy and we are not getting any inflationary pressure to move inflation back to 2 percent."

So is Michael Gayed right? Is the Last Great Bubble about to burst? I sure hope not because if markets lose faith in central banks, watch out, we're in for the Mother of all Busts. Unemployment will surge to unprecedented levels, government revenues will plunge and social chaos will ensue.

The Fed is basically telling Europe's big banks: "Don't worry about Angela Merkel, Wolfgang Schäuble, and the lack of major QE from the ECB. If they don't act, we will act in a forceful manner allowing you to use our balance sheet to shore up yours."

And that ladies and gentlemen is huge news for markets because it sends a strong message to short sellers salivating at the prospect of a eurozone collapse that the Fed isn't about to stand by and let it happen. Why? Because a eurozone collapse will unleash those deflation demons and ensure the U.S. and rest of the world are heading for a protracted period of debt deflation.

Even the threat of more QE from the Fed is enough to send shivers down short sellers' spines which is why you will likely see risk assets rallying during the second half of October and into year-end. Pay attention here to the ten-year Treasury yield (^TNX), the euro/USD exchange rate, crude oil prices, and small cap stocks (IWM) which have led the rally out of the selloff earlier this week.

As far as stocks, I've said it before, the real risk in the stock market is a melt-up, not a meltdown. We're going to get a massive liquidity rally unlike anything you've ever seen, then you'll need to worry about the massive hangover and protracted debt deflation, which remains my ultimate endgame. ....What's the biggest risk to my scenario? A significant crisis of confidence if the Fed actually does engage in more quantitative easing and market participants think it's way behind the deflation curve. That's the scenario that keeps James Bullard and Janet Yellen awake at night but for now, I wouldn't worry about any deep crisis of confidence.

The key here is whether the market perceives the Fed do be behind the deflation curve, not the inflation curve. As I've repeatedly warned, the real concern is about the Euro deflation crisis and whether it will spread to the United States. For now, global stock markets are not worried, bouncing back vigorously from the latest selloff, but this could change and the future of the eurozone remains very fragile.

Importantly, the biggest policy mistake the hawks on the FOMC are making is ignoring global weakness, especially eurozone's weakness, thinking the U.S. domestic economy can withstand any price shock out of Europe. If eurozone and U.S. inflation expectations keep dropping, the Fed will have no choice but to engage in more QE. And if it doesn't, and deflation settles in and markets perceive the Fed as being behind the deflation curve, then there is a real risk of a crisis in confidence which Michael Gayed is warning about. Perhaps this is the real reason why big U.S. banks are loading up on bonds (not just regulatory reasons).Economists are trained to view inflation as a lagging indicator but in a deflationary environment, inflation becomes a leading indicator. Many will argue against this assertion but this is the biggest risk and I think Bullard and Yellen understand this, which is why the Fed might ease up on QE at their next meeting and leave the door open to more QE down the road.The basic problem with developed economies today is lack of good paying jobs with benefits and very high public and private debt. In this environment, job insecurity is running high and severe under-employment is masking an even deeper structural problem in the economy. This too is complicating the Fed's decision to raise rates.

So when I listen to overpaid hedge fund gurus lambasting the Fed for engaging in quantitative easing, I roll my eyes and ignore their whining. If the Fed didn't engage in massive QE, more banks would have failed and unemployment would have surged to Great Depression levels. Some think this is a good thing but I can't understand their twisted logic.

As far as the latest rebound in stocks, it's obfuscating many well-known prognosticators. The huge volatility in the stock and bond market is something we better get used to. Forget all your technical and fundamental models, volatility will make mince meat out of them. There are two basic scenarios I want you to think about very carefully. First, the U.S. economy keeps growing and will lead the world out of any further weakness. If you believe this, then bet on a big rebound in oil and load up on energy (XLE), oil services (OIH), commodities (GSG) and materials (XLB).

The second scenario is that eurozone's deflation crisis will continue wreaking havoc on U.S. inflation expectations as the mighty greenback keeps surging. If you believe this, then you will use any rallyin energy (XLE), oil services (OIH), commodities (GSG) and materials (XLB) to shed positions or short these sectors. Some are loading up on utilities (XLU) and REITs (VNQ) for extra yield but I would be careful with all high dividend plays at this stage because in a deflationary environment, some of them will get slaughtered.Of course, if the Fed does surprise markets and engages in more QE, it will have an impact on interest rates, the U.S. dollar and risk assets across the board. This is where things get tricky and perhaps scary, especially if markets perceive the Fed as being behind the deflation curve.

The question now is: with equities having rallied back, "Is it Safe?" to take a more aggressive position on risk assets. The answer is probably yes, but still with great caution.

Equities are still overvalued by reliable metrics, although a bit less so than at the end of August. Q3 earnings reports are coming somewhat mixed, but do not yet show signs of any surprising weakness.

Bonds, which were already overvalued in late August, are now more overvalued and are at risk of giving back their recent sharp price gains if US economic data remain on the strong side.

What investors need to be wary of is a series of bond sell-offs which trigger equity sell-offs. This would be the reverse of the pattern witnessed throughout the period of increasingly accommodative monetary policy as measured by the growth of the balance sheets of the US Fed and other major central banks.

I understand Ted's concerns but if deflation creeps into the system, bonds are most certainly not overvalued. They will be the only asset class that protects you from massive deleveraging.

As far whether this rebound is safe, it really depends on which sectors we're talking about. For now, I continue to favor small caps (IWM), technology (QQQ) and biotech shares (IBB), including smaller biotechs (XBI). I don't see any evidence that the "Last Great Bubble" is about to burst and I still think you're better off sticking with the old adage "Don't fight the Fed."

Below, hedge fund manager Kyle Bass warns the end of QE will shake up markets. I wouldn't bet on any end to QE and think the real fireworks will come if there is more QE down the road. I also posted a clip of Dustin Hoffman and Laurence Olivier in the movie Marathon Man (h/t, Ted Carmichael).Please spread this blog post around and feel free to comment on it when I post it on Seeking Alpha. I remind all of you to keep clicking on the ads here and I'm still waiting for many institutions to follow some big name funds and subscribe to this blog via PayPal on the top right-hand side (I will provide you with a confirmation email for reimbursement).

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